Business

This is a guest post by Matt Wensing, a good friend and someone I admire. Matt is the CEO of StormPulse, an incredible service that helps customers plan better against weather risks and protect their assets, employees and maintain business continuity. I am happy to start this guest writer series with a post by Matt (twitter: @mattwensing). Have you written yours yet?As an aside, you can see Matt’s stand on value creation and pricing in GigaOm.

Stormpulse in action at the White House

As an entrepreneur, I’m used to working under constraints. The best definition of entrepreneurship I’ve ever heard is “the pursuit of opportunity without regard to resources currently controlled” (Howard Stevenson, HBS). I like how the usage of “without regard” leaves you wondering if the entrepreneur is noble and brave or mentally deranged.

My friend and I bootstrapped Stormpulse for 5 years (2007-2012), making ends meet with a smattering of friends and family money and customer payments. In late 2012, we finally succeeded at raising capital from professional investors. The bootstrapped years were a long and difficult road, but most would argue that those years made us stronger.

Did they? With confidence, I can say that we became accustomed to constraints. The good kind (the kind that force creative solutions), the bad kind (which limit you for ‘no good reason’), and the ugly (which force you to choose between cutting off your right arm or your left leg).

So here is the riddle: how can you identify a good constraint or a bad constraint? And is that the purpose of fundraising, to remove constraints?

Removing constraints for the sake of removing them is a mistake. Some constraints are good because they reflect limitations which your business will certainly encounter eventually. Shielding yourself from those constraints by raising money could also prevent you from taking on the challenge of overcoming those constraints in a more profitable and innovative way.

On the other hand, some problems fit the old adages such as “the cost of doing business” or “you gotta have money to make money.” Sometimes you need to place a bet, but you can’t afford the table stakes. This prevents you from being able to validate aspects of your business model.

And therein lies my answer—for now. Constraints are good when they embody a limitation that must be overcome for your business to scale. “Buying success” (removing the constraint through fundraising) will ease the short-term but may introduce a crippling flaw that will limit you later.

Constraints are bad (some also call them “artificial”) when they originate from a lack of resources that doesn’t reflect the market’s challenges. You simply don’t have money because you are a poor entrepreneur with only a vision. Wrong time, wrong place, no believers. You must, through no fault of your own, start from zero, comparative to certain peers.

That is a constraint in the psychologically-hardest sense, because it is very unfair and uncaring. It will only be considered good in hindsight if it’s overcome. If it isn’t, you will die unnoticed, and it is likely that no one will even care to tell your tale.

A simple and clean explanation of how stores price for Black Friday from WSJ,

Here’s how it works, according to one industry consultant describing an actual sweater sold at a major retailer. A supplier sells the sweater to a retailer for roughly $14.50. The suggested retail price is $50, which gives the retailer a roughly 70% markup. A few sweaters sell at that price, but more sell at the first markdown of $44.99, and the bulk sell at the final discount price of $21.99. That produces an average unit retail price of $28 and gives the store about a 45% gross margin on the product.

So if you wonder what happens to the sweater for its price to go down from $50 to $21.99 at 6AM Friday after Thanks Giving and then back up to $30, the answer is nothing. It is the customer mix that changes helping retailers price discriminate (legally) and maximize their profit.

One such way (to price discriminate legally) is changing the buying experience. Create enough pain in the buying experience , like asking them to skip sleep, wake up early and schlep to the store at 6AM, such that most (if not all) in the 60 to 100 range will find it not worth it, just for getting additional consumer surplus. That is why there is a 6AM deal.

Most in the 30 to 59 range will likely do that sacrifice to score the sweater at lower price.

This morning I heard the news about GrubHub and Seamless merger. How do these services work?
From a end customer, who is trying to order take out, this is the flow,

From a restaurant point of view this is how it works,

Both these pictures come from Seamless website.

In the same NPR story about the merger a restaurant owner had some strong words about Seamless’ commission and business practices.

“The more business we bring Seamless, the more commission they charge us,” says Pedro Munoz, who owns Luz, a Latin-American restaurant in Brooklyn. When his monthly orders increased to over $10,000, Seamless raised its take from 10 percent to 14 percent. Munoz couldn’t believe this. When he orders more from his vegetable supplier, the price goes down. With Seamless, the opposite was happening. (Source: NPR)

And then when the restaurant owner tried to negotiate he was met with threat,

“I asked them, ‘I’m bringing in three times as much money to Seamless as before. Can we negotiate the fees?'” he says. “They said they could drop me any day, and they don’t negotiate fees.”

This led me to tweet this,

Why are the food delivery Startups bent upon squeezing small businesses – the very segment they say they serve? Not cool folks.

But upon further reflection I want to balance my statement and discuss rationally whether or not services like Seamless and GrubHub help restaurants and whether their pricing practices are acceptable.

Services like these are two sided markets. On one side they have hungry end consumers who want to order takeout easily (preferably from single website, app etc). On the other side they have restaurants that want to sell more takeout by reaching customers they otherwise would not be able to reach. The market maker or the middlemen, GrubHub and Seamless, take a cut when they enable this transaction.

In a balanced two sided market there is new value created for all three players and not just value redistribution (think Groupon). The market maker gets fair share of net new value created for both sides. In some cases they may choose to let one side capture all its value without getting their share and get all their share only from the other side. That is what happens with GrubHub and the rest.

In this case the end consumers are happy and get more value from simplicity but these sites decide not to charge these consumers for that value. That is okay. Besides even though these consumers see value their reference price is low (or $0) and there are multiple alternatives (pick up the phone and order) and hence it is difficult to charge them a price to place an order.

The restaurants are able to make new sales that they otherwise would not have made. Well may be all sales are not truly incremental that depends on your existing sales channels and customer base. GrubHub and the likes get a share of this value by charging a percentage (10%) on the sales (not profit generated from the sales).

So should your restaurant do it?

If the profit from the new sale makes up for the commission you pay to GrubHub then you should take advantage of it. Note that I said profit and not just sales.

All your food costs are marginal. Say you order too much raw materials with not enough sales to match you can always fix that with better ordering and inventory control. All your rent/mortgage, even employee costs, etc. are fixed costs. When you sell through GrubHub you should add the commission to your marginal cost.

Gladly do GrubHub if:

Price of food order LESS

Commission to GrubHub LESS

Cost to prepare that single food order IS GREATER THAN $0.

That is as long as every order is profitable, do it. If not don’t bother.

So why do they charge you more when they bring you more sales?

Shouldn’t they charge you less when you give them more business like you do your vegetable vendor?

Unfortunately no. Actually you are the vegetable vendor here. If they deliver you far more incremental sales (that is also profitable) then yes they can charge you higher rate of commission. That is just effective pricing. You do the same math as above with the new rate. As long as you make money on every single order at the new rate, do it!

BUT

About those marketing charges these sites want to charge you,

But then little things started bugging Munoz. There was a $150 a month “marketing fee” that he couldn’t understand, and Seamless only paid him every 30 days, which left him chronically short of cash.

Say NO. NO. NO.

You have your share of risk. You took mortgage, bet your future and your family’s future on this business, take loan to buy food and serve. That is enough. You do not have to offset their risk. When GrubHub and such startups decide to run a business they have their share of risks. The primary risk is customer acquisition and retention. It is their risk and theirs alone. You amply compensate them in the form of commission on sales generated. It is up to them to make a net profit from that by doing whatever it takes to acquire and retain their end customers. You do not have to carry that risk for them.

And you should get paid right away and not let them keep the cash for 30 days.

They say,

But all that advertising and email marketing are about their site, apps and service – to acquire and retain email addresses of end consumers. Not to advertise your business. It is their cost of doing business. Their risk.

Their costs are just that, theirs. Not yours. You pay for the value you get from the incremental sales. You are done. Demand to get paid when you sell food.

So by all means give a real hard look at these services. For your restaurant these services most likely help generate profitable sales if the commission is just 10-15% and you do not have to pay anything else. They do create value but don’t let them pass on their risks to you.

Note: There may be cases where you may still make total profit while not every single sale is profitable. That is a complex math to figure out for your business and you have enough worries already. Keep it simple and focus on profit from each order.

e360: How do you think about the tension between growing a business and lightening our collective environmental footprint?

Lowry: I think the answer is moving from products of consumption to products of service. Ultimately we need to get to close to zero resources used in order to get the job done, in order to be truly sustainable. But for me that is not a business that depends on selling more and more liquid no matter how concentrated. It’s a business that makes money every time somebody’s clothes get clean. It’s probably a format where a laundry detergent lives in a washing machine. When dirty, soapy water comes out of the back of the machine, the soap and the water get separated from the dirt and the soap and the water go back in the front of the machine and the dirt that comes out is compost. And we would get a little fee for the usage of the detergent.

This is a great thought and it mirrors what Ted Levitt wrote about customers buying holes vs. drill bits. You can also see the parallel to the newer “Customer Job to be done” metaphor. That is customers have a need to fill or a job to be done. It is that need/job marketers should focus on and build offerings that do that job far better than alternatives.

In that context you can see what Adam Lowry means by selling detergent vs. selling clean clothes. Customers are hiring detergents to get cleaner clothes. That is the primary job for detergents. And he suggests getting a fair share of the value created in the form of service fee vs. price for detergent. This is very concise and cogent description of what customers want, why they hire products and how marketer gets paid.

Then Lowry goes on to suggest a technology that can achieve the end goal. That is not as important. Technology and service innovations can offer any number of ways to fill the primary need of clean clothes.

That said let us not forget that customers do not buy products for just one reason. A product won’t be hired in the first place if it does not do the first order job better than alternatives. But first order jobs, like cleaner clothes, is table stake. A product is never hired for just one reason. It is hired for a basket of reasons. Here is a quote from 1967 issue of Journal of Industrial Economics,

First, he tries to identify these desires. To do this he now has all the aids of marketing research. If he only researches into which detergent the consumer considers to wash cleanest, he may miss the fact that the consumer now also wants her detergent to be pleasantly perfumed.

Detergents as consumption products are not just about clean clothes. It was perfumes in 1967 but it is lot more than that these days. Thanks to marketing magic these detergent brands have become lifestyle brands. Clean clothes have become utilitarian job and premium brands are hired for higher order jobs they promise to do.

Thinking of detergent as providing cleaner clothes is great ‘Job to be done” thinking, but it will be successful in the market only if it can address some or all of the higher order needs. Unless of course the marketer changes the reference with positioning, may be appealing to greener motives is the new higher order job, and that explanation is for another day.

Like this:

In the Corporate Intelligence section of The Wall Street Journal their business editor asks surprisingly wrong questions about a business.

Why does Time Warner Cable need this extra money when it seems to be doing so well?

Why doesn’t Time Warner simply call a price increase for what it is?

Granted he projects the first question on us readers, but all the same. I do not think the first question deserves takedown. Since when did effective pricing to maximize profits needed reason?

Businesses do not stop adding shareholder value after some point, Be it passing on the additional income as dividends to shareholders or ploughing it back into new opportunities you don’t expect a business to say, “I think we have done enough, let us not do any more”.

Second question on the reason and how the fee was messaged. That is effective pricing 101 and we have seen this perfectly executed several times by many great companies. Can you think of Starbucks? Effective pricing is not just about setting price points but effectively communicating those changes. You cannot blame any business for not calling price increase as price increase.

There are always other reasons. That is part of the effective price communication message.

Let me be pose an equally wrong question back to him on WSJ pricing,

“WSJ raised my quarterly subscription by 50%. Why does Dow Jones need this extra money when it seems to be doing so well?”